Nearly every company has faced or will face financial distress at some point during its lifetime. Some companies may be able to crawl along indefinitely with a debt-free capital structure, but most have taken on some form of debt. Leveraging a company with debt can help it grow at a faster pace but can also cause all sorts of problems when business is not going according to plan. In fact, even when a company is performing well, debt obligations create major hurdles. Private equity sponsors commonly lever companies with debt to extract returns through dividend recaps, and an IPO is one possible exit for these sponsors.
When a company cannot successfully pay down or refinance debt when it is due, creditors have the power to seize assets or drive the company into bankruptcy.1 For companies hoping to conduct an IPO at some point in the future, successfully navigating these situations is essential. Companies restructure debt through debt-for-equity swaps, renegotiated terms (like an “amend and extend”), or early repayment. Debt restructuring occurs both through in-court proceedings and through private negotiation.
Pros and Cons of Restructuring Out of Court
Where possible, out-of-court restructurings are almost always preferable to Chapter 11 proceedings. Despite the inability to obtain in-court benefits, which will be discussed later in the article, companies save time and money and, with some negotiation, can often reach similar agreements outside the courtroom. This is especially true for pre-IPO companies, which tend to have simpler capital structures, fewer creditors to negotiate with, and less cash sitting around for bankruptcy expenses.
Because companies pursuing an out-of-court restructuring lack a court-authorized order to fall back on, they must handle the entire process—nullifying old agreements, reaching new agreements, etc.—investor by investor. Outside of court, the debtor cannot force creditors to accept anything less than full repayment. In contrast, through court proceedings, creditors can be required to accept cents on the dollar or equity as a partial recovery.
How to Restructure Without Court Authority
Secured lenders are likely to get the best treatment: a full recovery. These lenders are highly unlikely to negotiate with smaller, pre-IPO companies because they know that they would likely receive all their money back if the issue were taken into court, which the company is trying to avoid. The secured lenders leverage will depend on the value of the collateral it is entitled to, though, so they will be more willing to negotiate if their collateral appears to be worth less than the amount of the loan outstanding.
The company’s equity holders also see similar treatment in out-of-court restructurings, essentially getting wiped out.
The way a company negotiates with trade creditors and vendors, on the other hand, may be different for out-of-court restructurings. Despite being senior only to the equity holders in the capital structure, these creditors and vendors wield significant power. Without offering members of this class a 100% recovery on what is owed, they can simply stop doing business with the company, ruining any future of financial success for the distressed company.
Private investors and unsecured debtholders sandwiched between the banks and the trade creditors may also have a different experience in an out-of-court restructuring. These lenders typically receive only what is left over, after the banks and trade creditors are taken care of first. Often, the result is the private investor getting most of the equity in the company (usually worth very little), except for a small portion which is retained as an incentive for the management team to improve operations.
Upon exiting debt restructuring a company’s go-forward financing is often composed of private equity investment either through purchase of shares or private investor lending.
Crossmark Holdings, Inc, a company backed by private equity firm Warburg Pincus, provides sales and marketing services. On July 29, 2019,2 Crossmark announced that it had successfully reached an agreement with lenders to reduce its debt by 75%, or around $400 million. Prior to the restructuring, Crossmark’s capital structure looked like the following:
|1L Revolver||$52.5 Million||June 30, 2019|
|1L Term Loan||$420 Million||December 21, 2019|
|2L Term Loan||$90 Million||2020|
In April 2019, Moody’s downgraded the rating of Crossmark’s debt following a missed interest payment.3 Crossmark was levered at close to 11.0x debt-to-EBITDA, and a new capital structure was needed.
All the lenders agreed to the following restructuring plan outside of court:
- First lien term loan holders extinguished $400 million of debt outstanding in exchange for (1) 100% of Crossmark’s equity, subject to dilution (see warrants below) and (2) $75 Million of new debt.
- Second lien term loan holders were given five-year warrants in exchange for the $90 million in debt owed. The warrants allow the holders to receive 7.5% of Crossmark’s pre-diluted equity upon exercise.
- Crossmark entered into a new asset-based $75 million revolving credit facility and a $23 million letter of credit facility. The company borrowed $45 million under the revolver to repay a $30 million bridge loan at the close of the restructuring.
To right-size the capital structure, Crossmark handed over control of the entire company to the creditors. The revised debt-to-EBITDA for the company is around 3.0x, which is a much more sustainable capital structure.
Overview of the Chapter 11 Bankruptcy Process
Chapter 11 of the United States Bankruptcy Code provides a platform for financially distressed companies to reorganize themselves under court supervision. The Bankruptcy Court provides certain benefits to the company filing for bankruptcy—the “debtor”—that are not available outside of the courtroom:4
- The court provides an “automatic stay,” preventing collection attempts from all creditors.
- The company can cancel unprofitable contracts and leases.
- The court can “cram down,” or force all creditors to follow a specified restructuring plan.
- Additional financing with super seniority status—called Debtor-in-Possession (DIP) financing—often becomes available to the debtor.
Once a company has filed for bankruptcy, it submits a plan of reorganization for impaired creditors to vote on.5 A creditor’s recovery depends on where it sits in the capital structure hierarchy. The following funnel-like image depicts the capital structure hierarchy and examples of common instruments for each category.
Fusion Connect, a software company founded in 1997, announced its emergence from Chapter 11 bankruptcy on January 14, 2020, about 7 months after initially filing for protection. Through the bankruptcy process, Fusion was able to eliminate about $400 million of debt. Several factors led to the bankruptcy:
- Fusion borrowed $680 million in secured debt to acquire two cloud-computing companies in 2018.6
- The acquisitions failed to meet performance estimates and significant accounting concerns began to arise, triggering debt covenant violations.
- In April 2019, Fusion defaulted on a credit agreement by failing to make a $7 million interest payment on first lien term loans.
- Fusion failed to file its 10-K, losing its listing on the NASDAQ.
At the time of its bankruptcy filing, Fusion’s capital structure was as follows:
|1L Revolver||$39.5 Million||May 2022|
|1L Term Loan A||$43.3 Million||May 2022|
|1L Term Loan B||$490.9 Million||May 2023|
|2L Term Loan||$85 Million||November 2023|
A valuation analysis showed that the first lien, second lien, and general unsecured claims were impaired. Fusion sought the approval of the creditors for a plan, which it detailed in an 8-K filing with the SEC. Under the plan, Fusion would transfer 97.5% of its equity to, and enter a new $115 million exit loan with, the first lien lenders in exchange for the elimination of about $590 million in debt. Additionally, the first lien lenders received $225 million of second lien takeback loans.
As part of the bankruptcy proceedings, a $59.5 million DIP facility was provided; the balance was repaid upon executing the restructuring agreement.
Fusion also proposed that each second lien lender would receive its pro rata share of warrants, granting them a total of 2.5% of Fusion’s equity in exchange for the elimination of debt.
Finally, the proposal would leave the unsecured lenders and current equity holders essentially wiped out. The plan received enough votes and the company was able to successfully implement its restructuring plan.
More details about Fusion’s bankruptcy proceedings can be found in their PrimeClerk docket.
Even though Chapter 11 provides many benefits, administrative and professional fees can quickly pile up, and the process can be delayed for long periods of time, prolonging poor financial conditions. Bankruptcy may also damage a company’s reputation. For these reasons, smaller, pre-IPO companies often find that Chapter 11 is not the best option for them. Some companies have successfully used Chapter 11 along their way to an IPO, such as iHeartRadio. To be fair, though, these companies generally are large and can benefit from their relative sizes, while most smaller pre-IPO companies will restructure out of court.
iHeartMedia was purchased by private equity firms Bain Capital and THL just prior to the financial crisis of 2008.7 The leveraged buyout placed a massive load of debt on the balance sheet that iHeart struggled with for years. In 2018, iHeart entered Chapter 11 Bankruptcy, through which it reportedly lowered its debt levels from $16 billion to just under $6 billion. In mid-2019, iHeart exited Bankruptcy in dramatic fashion, listing its shares on the NASDAQ in an IPO.
So far, the discussion of in-court and out-of-court restructurings has focused on evaluating a creditor’s recovery based on the value of the debtor. This provides an accurate picture of what creditors are entitled to as long as the valuation is correct. Because the valuation of a company determines which creditors are impaired, and how much of the reorganized equity pre-petition lenders are in line to receive, it can be a subject of hot debate in negotiations. Any company seeking to restructure its debt should first have a very strong understanding of the company’s valuation—this will allow the company to approach investors more effectively.
Common Restructuring Tactics
The examples shown above demonstrate impaired creditors exchanging debt forgiveness for equity. In reality, this is just one of many possible deals; some creditors may agree to a variety of concessions.8
Extend out the maturity date of the debt
Creditors may agree to extend the maturity date of an obligation. This often requires the debtor to make a sizeable down payment on the outstanding principal up front. The creditor may also adjust the interest rate or charge a one-time fee in addition to covenant adjustments. Doing this would give the debtor time to “right the ship” before having to repay a large obligation, essentially paying a fee now to kick the can down the road.
Change the type of interest paid
A creditor may agree to change cash interest payments to “Payment-in-Kind” (PIK)9 interest payments. Instead of requiring a cash interest payment, PIK interest will accrue as additional principal to be added to the debt balance. This reduces the financial burden of regular interest payments, allowing the debtor to grow without worrying about cash payments until it repays the entire principal (old plus new) in the future.
Exchange debt for debt
A creditor may agree to completely write off its debt in exchange for new debt (having a different maturity or different interest structure) with a higher seat in the capital structure, an equity conversion option, or another incentive.
Some creditors will agree to write off portions of debt or amend agreements if the company agrees to make significant changes. These changes often include selling off an unprofitable business segment or product line.
Restructuring debt can have significant accounting effects.10 Accounting Standards Codification (ASC) 470-60 establishes proper accounting guidelines for troubled debt restructurings, which arise when “the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider” (ASC 470-60-15-5).
Certain tax implications may also arise, including Cancellation of Debt Income (CODI) and NOL reductions.11
All companies that have taken on debt are at risk of financial distress when business does not go according to plan. These situations often require debt restructuring, either in court or out of court. For pre-IPO companies, out-of-court restructuring is usually preferable because the companies have simpler capital structures and fewer creditors to negotiate with. By understanding common restructuring tactics, the importance of valuation, and the accounting implications of capital structure changes, companies will be well-prepared to improve their capital structure.
- ABFJournal. “JPMorgan Chase Extends Springing Maturity Dates for GNC’s Loans.” 15 June 2020.
- O’Flaherty, Kevin. O’Flaherty Law: “Involuntary Bankruptcy Explained.” 8 May 2020.
- Califano, Tom; Simon, Daniel; Avraham, David. DLA Piper. “COVID-19: The benefits of US chapter 11 relief in a time of economic crisis.” 19 March 2020.
- United States Courts. “Chapter 11 – Bankruptcy Basics.” 20 June 2020.
- Biswas, Soma. Wall Street Journal. “Poised to Exit Bankruptcy, iHeartMedia Files for an IPO.” 3 April 2019.
- Practical Law Corporate and Securities. Thomson Reuters. “Debt Exchange Offers and Debt Restructuring Toolkit.” 20 June 2020.
- The Business Professor. “Payment in Kind – Definition.” 14 September 2019.
- Bragg, Steven. Accounting Tools. “Troubled debt restructuring accounting.” 27 July 2018.
- IRS. “Topic No. 431 Canceled Debt – Is It Taxable or Not?” 27 May 2020.
- Gross, Cliff; Hough, Jessica; Schockett, Paul; Alexander, William; Binstock, Jared. Skadden, Arps, Slate, Meagher & Flom LLP. “IRS Proposes New Section 382 Regulations To Further Limit Use of Tax Losses.” 27 September, 2019
- ASC 470-60-35-4 and 35-8
- Oflaherty-Law.com: Involuntary Bankruptcy Explained
- See Crossmark’s announcement at this article.
- Moody’s rating summary can be found here.
- DLAPiper: Benefits of Chapter 11 Bankruptcy
- USCourts.Gov: Chapter11 – Bankruptcy Basics
- For more information about the acquisitions, see this article.
- Wall Street Journal: “Poised to Exit Bankruptcy, iHeart Media Files for an IPO”
- Thomson Reuters Practical Law: Debt Exchange Offers and Debt Restructuring Toolkit
- TheBusinessProfessor.Com: Payment in Kind – Definition
- AccountingTools.Com: Troubled Debt Restructuring Accounting
- For more information about tax implications, see IRS Topic No. 431: Canceled Debt – Is it Taxable or Not? and Skadden: IRS Proposes New Section 382 Regulations to Further Limit Use of Tax Losses (September 27, 2019)